While both the S&P 500 and Dow Jones Industrial Average finished 2013 at record highs, Japan’s long suffering Nikkei 225 gained almost 57 percent last year, its best performance in more than four decades.

Much of the credit for that gain goes to Prime Minister Shinzo Abe who, upon his election, took a cue from the US Federal Reserve and undertook a massive stimulus package valued at ¥20 trillion in an attempt to break a two-decade long deflationary cycle. With inflation running at 1.2 percent in November, Japan is getting close to its 2 percent inflation target.

The question now has become whether Japan can repeat that performance in 2014 and, so far, sentiment is mixed. But we remain bullish.

With the Nikkei ending 2013 at 16,291, some bullish predictions point to the index hitting 20,000 this year. Other bearish predictions look for the index to close out 2014 at 15,000 on the expectation that Abe’s program of both monetary and fiscal stimulus loses steam, particularly with the country’s sales tax slated to jump from 5 percent to 8 percent in April.

To be fair, both sides have valid points.

Household spending jumped 3.7 percent in September as consumers anticipated the tax hike, then increased by just 0.9 percent in October and inched up by just 0.2 percent in November. While December’s spending data won’t be released for another two weeks, it’s likely to be in line with October’s reading thanks to the Omisoka (New Year) holiday and well below years past, thanks to all of that demand being pulled forward.

While that tax hike is bound to have a negative impact in the first quarter—consumer spending accounts for about 60 percent of gross domestic product (GDP)—there are other encouraging signs that the Japanese economy is truly on the mend.

After declining for 17 months in a row, wages excluding bonuses and overtime were unchanged in November. That’s largely due to the fact that the Japanese labor market is showing signs of improvement with one job for every applicant, the greatest number of available jobs since 2007.

With annual wage negotiations coming up in the spring, the tightening labor market should result in at least modest salary gains in the latter part of the year, helping to offset some of the impact of the higher sales tax.

The government has also announced a fresh ¥20 trillion stimulus package ahead of the tax hike. The package includes ¥10 trillion in loans to small- and medium-sized companies, many of which have already been made, and sums dedicated to reconstruction and infrastructure projects that should result in about ¥5.5 trillion of fresh spending.

In the wake of these measures, a recent Japanese newspaper poll of large company managers in the country showed that more than 80 percent believe the tax hike won’t torpedo the recovery. About 77 percent of respondents said they expect the economy to recover any lost ground in the second half of the year and another 6.5 percent didn’t anticipate any impact at all.

And while a number of emerging market economies are expected to suffer bouts of economic weakness thanks to the US Fed’s tapering, the wind down of American quantitative easing should actually benefit Japan.

The consumer may be the cornerstone of the Japanese economy, but exports will be a major growth driver for the country in recent months. Thanks to the US dollar strengthening even as the yen weakens thanks to the massive Japanese spending program, exports have been showing signs of improvement for several months now. But in November the volume of merchandise exports shot up by 6.1 percent after rising 4.4 percent in October.

With the yen currently trading at about ¥104 to the dollar, the country’s exports are becoming increasingly competitive, especially as many Chinese exports are struggling against a tightening labor market and increasing labor costs. That helped push Japanese exports to the rest of Asia up by 5.9 percent in November and offset a slight slowdown in shipments to the US and Europe.

The shipment mix should improve over the coming year, as the US economy continues its slow but steady recovery and Europe emerges from its recession.

Given the numbers of moving parts at play, the Nikkei is likely to finish out 2014 somewhere in the neighborhood of 18,000.

For the index to actually hit 20,000, a large number of structural reforms need to be introduced to liberalize the nation’s labor system and roll back a number of its more protectionist market measures. So far, Abe and his party have successfully pushed through bills opening up the nation’s electricity sector and are attempting to eliminate a number of protectionist measures in the country’s agricultural sector, but no meaningful progress has been made on labor or tax reform.

Labor reform will remain a challenge, but the Japanese equity market still has the wind at its back in the form of a relatively weak yen, rising inflation, growing exports and the recent introduction of the Nippon Individual Saving Account scheme. Roughly similar to American Individual Retirement Accounts, the program allows Japanese savers to invest on a tax-deferred basis and should funnel more money into Japanese stocks.

Portfolio Updates

All of our Chinese holdings have posted moderate declines since we rang in the New Year a little over a week ago, as measures of both manufacturing and service sector activity slipped in December. The government’s manufacturing Purchasing Managers’ Index (PMI) fell to a four-month low of 51 while the nonmanufacturing PMI dropped from 56 in November to 54.6.

While any reading above 50 indicates continued growth, the decline indicates that Chinese demand for goods and services is weakening.

But inflation has also slowed in the country, with its consumer price index increasing just 2.5 percent and producer prices falling by 1.4 percent, the 22nd consecutive month of declines. That’s an indication that cutbacks in Chinese government spending and tighter monetary conditions are working, making further austerity measures unlikely with gross domestic product growth expected to come in at 7.6 percent in the final quarter of 2013.

This dynamic gives the government more leeway to follow through on its November pledge to allow the market to play a decisive role in the prices of resources such as oil and natural gas, which will benefit China Petroleum & Chemical (NYSE: SNP). One of the company’s greatest headwinds has been price controls, so the government ceding that role to the markets will have a significant impact on profitability.

The government’s planning agency has also announced that it will move ahead with higher rates for tap water, a boon for Beijing Enterprises Water Group (Hong Kong: 371). Operating more than 90 water supply and sewage treatment plants, the company will benefit from higher, more market-oriented waters rates that better reflect the cost of treatment and delivery.

China Petroleum & Chemical remains a buy up to USD125 and I’m bumping Beijing Enterprises Water Group’s buy target to HKD5, to reflect its soon-to-be improved pricing power.

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